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Emerging Market Slump Hides Opportunities Within

It’s an election year across the developing world, and that means both political and economic instability. As a result, fund managers see greater volatility ahead for emerging markets.

On the other hand, there are pockets of stability and opportunity within those markets. Plus, in some regions, economic growth and investment expansion continue to outpace what’s taking place in the U.S. and Europe.

“Without a doubt, this is going to be a very tricky year, as it’s dominated by elections, and to be elected incumbents will do what it takes to win at all costs,” said Maria Negrete-Gruson, emerging-markets portfolio manager for Artisan Partners, in an interview with ThinkAdvisor. “This means spending beyond [these countries’] means, inflation can creep up, and the central banks intervene or postpone action.”

But while the overall outlook for emerging markets this year is “not pretty from the top down, since it catches them in really bad shape in terms of their fiscal and monetary discipline,” Negrete-Gruson says, it does also offer investors “robust opportunities” in the consumer-discretionary sector, for example.

This group has plenty to offer investors, she says, though not necessarily in the rapid expansion of price-to-earnings multiples. “But the earnings power ticks along not with global trends but more with their business models and market penetration,” the analyst explained. “It’s about nitty-gritty, ground-up investments.”

That strategy does expose you to a nice dose of risk — which you want to play in a way that works in your favor.

“In an environment like this one, of maximum volatility, opportunities emerge, and we try and take advantage of them,” Negrete-Gruson said.

Some Artisan investments, she point out, are in companies that are paid for their exports in dollars, and that minimizes currency exposure — such as iron-ore producer Vale of Brazil.

Are the upsides of these opportunities enough of a reason to invest in emerging markets?

No Pain, No Gain

“When an asset class has issues, it can be beneficial to invest when the [maximum] pain has been reached,” noted John Derrick, head of research for U.S. Global Investors and a manager of the firm’– Emerging Europe Fund, in an intervew. “The emerging markets are not going away and will be [the world’s] growth vehicle for the next decade or so.”

The overall emerging-markets benchmark index fell about 2.5% in 2013. Plus, it’s down a total of 6% for the past three years, while U.S. equities have risen about 60% in the same period.

“A Merrill Lynch survey recently found that fund managers are underweight in the emerging markets by the greatest margin since the financial crisis of ’09,” Derrick said. A lot of the money that’s been leaving the sector, he says, is tied to the news of Federal Reserve tapering, along with currency issues in countries like Turkey.

“The emerging markets, though, have been forced to rebalance and make painful adjustments, and they may be further along than the U.S. and Europe,” he said. Plus, emerging markets are expected to have higher growth levels than the developed economies.

China, for instance, expected to have economic growth of 7%-8% last year. It achieved 7.7% growth. “So they hit their number,” Derrick noted, adding that U.S. growth should continue to be 2%-3% per year.

“You want some exposure — you don’t want it to dwindle,” he said. A level of 10%-15% of assets, which matches the global market capitalization ratio of the emerging markets, makes sense.

Derrick acknowledges the risks involved but doesn’t see volatility rising dramatically this year in the group.

Nor do businesses, apparently.

The UN Conference on Trade and Development’s latest report says that the developing economies attracted close to $760 billion, or 52%, of the nearly $1.5 trillion foreign direct investment that moved around the world in 2013. Russia and other former Soviet-bloc states drew about $125 billion.

Overall, more than 60% of FDI went into the emerging markets — a strong statement about their longer-term outlook.

"In the medium and long term, there are good opprotunities," said Negrete-Gruson. "And when some investors are spooked and run out door … you can pick up great companies with great quality and growth, as well as low valuations."